1) The document discusses concerns over the Indian equity market being overdone due to fears over US Federal Reserve rate hikes. 2) It notes that the correction in the Indian market was more than in other emerging markets, and that earnings growth remains strong. 3) The summary concludes that the worst of the correction may be over, and that the market has likely priced in expected rate hikes already.

1. June 03, 2006Visit us at www.sharekhan.com
More than our fair share of pain
We believe that the concerns over the Indian equity market are being overdone
Sharekhan Ltd
A-206, Phoenix House, 2nd Floor, Senapati Bapat Marg, Lower Parel, Mumbai - 400013, India.
w We believe that the concerns over the Indian equity
market are being overdone. We believe that the worst
is over for our market.
w While the correction in our market as well as in the
other equity and commodity markets across the
emerging economies happened because of the fear that
the US Federal Reserve (Fed) may continue to hike the
Fed rate, we believe that the rate hike has already been
discounted by market players.
w Consequently any pause taken by the Fed in the rate
hike exercise will be a big positive for them.
w To be on the safer side, we prefer to take exposure to
large-cap stocks rather than mid-cap and small-cap ones.
With a good run-up in the prices of the mid-cap and
small-cap stocks, the gap between the valuation of the
CNX Mid-cap 200 and the Sensex has narrowed down
significantly over the last two years.
Expectation of another Fed rate hike takes its toll
The heading of our last ValueLine editorial said "Strong
earnings but watch for unpredictables" and the market's
movements in the following month certainly were
unpredictable! In our view, the two key determinants of
the market direction over the next few months are going
to be (1) earnings and (2) the Fed. While the earnings
growth and the macro-economic data remain robust (more
on that later), the changing expectations on the US interest
rates have been affecting all the emerging markets. While
the fall was exacerbated in India's case because of the huge
build-up of leveraged positions, the other emerging markets
across the world fell on the interest rate concern.
As explained in our earlier notes, volatility is higher now
because we are approaching a point of inflection—earlier
anyone could predict what the Fed would do since it was
raising rates by 25 basis points in each meeting (as
happened in the last 16 meetings) but now we have reached
the point where opinion is sharply divided on whether the
29th June Fed meeting would result in a rate hike or not.
The Fed itself said that it would look at the economic data
of the May-June period before firming up its view. To quote
the Fed: "The Committee judges that some further policy
firming may yet be needed to address inflation risks but
emphasises that the extent and timing of any such firming
will depend importantly on the evolution of the economic
outlook as implied by incoming information.'' Thus we
are now in a situation where the markets are reacting wildly
to each piece of data and trying to look for clues to growth,
inflation and interest rates. This is best reflected in the Fed
future rate for July which has swung between 30% chance
and 80% chance of a rate hike in the last 20 days.
Correction overdone, India suffers more than its fair
share of pain
While there is no doubt that the Indian market's behaviour
in early May was unsustainable, we feel the froth has been
squeezed out and the correction was overdone. Our reasons
are as follows.
w We believe that the Indian equity market has had more
than its share of pain compared with its peers as the
BSE Sensex has corrected much more than the other
such emerging market indices. India, which at its peak
was outperforming the other markets, had fallen far
more than most other emerging equity markets and
global commodity markets by June 1, 2006.
w India's share in foreign institutional investor (FII)
outflows among the emerging Asian markets has been
much more than that of its peers.
w The concerns over the Fed rate hike now seem to be
very much discounted as can be seen from the increase
in the US Fed futures rate. By June 1, the Fed future
was implying an 80% probability of a hike which means
that the markets had almost fully factored in that there
would be a rate hike.
w The recent data on US economy has been benign. Our
expectation as discussed earlier remains that a slow-
down in the US housing sector would cause a soft landing
for US economic growth. A pause in the rate hike by the

2. 2 June 2006Sharekhan
market outlook More than our fair share of pain
Source: Bloomberg, Sharekhan Research
w Fed futures for August 2006 and November 2006 are
quoting at yields of 5.25% and 5.32% respectively.
w The market has fully discounted one rate hike while
being unsure about the second one.
Fed futures rate has discounted one rate hike
Fed Futures Rate (%)
4.99
5.08
5.12
5.15
5.18 5.17
5.14
5.03
5.18
5.25
5.29
5.31 5.32 5.31
4.80
4.90
5.00
5.10
5.20
5.30
5.40
Jun-06 Jul-06 Aug-06 Sep-06 Oct-06 Nov-06 Dec-06
Apr-06 Jun-06
We believe that at least one more hike in the Fed rate has already been fully discounted in the commodity and equity
markets as is reflected in the upward shift in the Fed futures rates. In case the Fed decides to take a pause in the rate
hike exercise, it will have a positive impact on the equity markets of the emerging countries.
...whereas the worst seems to have been discounted
Latest US economic data benign
Source: Bloomberg, Sharekhan Research
w Residential building sales dropped 1.1% in April 2006,
the biggest decrease since January 2004.
w Pending home sales slid 3.7% in April, the third straight
decline.
w The non-farm sector added just 75,000 new jobs in
May 2006, the lowest since November 2005.
w The ISM Manufacturing Index slowed down for May 2006.
w The number of jobless claims has also increased over
March-May 2006.
The latest data on the US economy presents a benign picture of the economy. The manufacturing growth slowed down last
month and construction spending fell for the first time in almost a year, as indicated by the Factory Index released by the
Institute for Supply Management (ISM), US.
52
53
54
55
56
57
58
59
Jun-05
Jul-05
Aug-05
Sep-05
Oct-05
Nov-05
Dec-05
Jan-06
Feb-06
Mar-06
Apr-06
May-06
0
50
100
150
200
250
300
350
400
Factory Index (LHS) Non-farm payroll in '000 (LHS)
Latest data on US economy shows benign picture
Fed would be a positive for the emerging markets (see
the chart named “Fed rate hike—a pause, sooner the
better” below).
w According to our analysis, rumours of huge redemption
in India-dedicated funds (from Japan and elsewhere)
are untrue. The data shows that as of end of May,
adjusted for the currencies and prices, the assets under
management in these funds are at similar levels as at
end April.
w Meanwhile, the much talked about Indian growth story
remains intact with strong growth in gross domestic
product as well corporate earnings.
w After the correction the market's valuation has reached
attractive levels at 14.3x FY2007E earnings. On June 1,
2006, at the level of 10,071, the Sensex' valuation was
virtually at the bottom of 13.8x its one-year forward
earnings.
w To be on the safer side, we prefer to take exposure to
large-cap stocks rather than mid-cap and small-cap
stocks. With a good run-up in the prices of the mid-cap
and small-cap stocks, the gap between the valuation of
the CNX Mid-cap 200 and the Sensex has narrowed down
considerably over the last two years.

3. 3 June 2006Sharekhan
market outlook More than our fair share of pain
Source: Ministry of Commerce and Industry
w Economic growth subdued during second and third
quarters of FY2006 due to natural calamities.
w Growth bounced back in Q4FY2006 as anticipated by
us.
w There have been ten instances of a rate hike exercise
by the Fed over the last 45 years.
w In the instances when the US Fed rate hike was not
followed by recession, the emerging markets performed
even better.
Fed rate hike—a pause, sooner the better
IIP sparkles with manufacturing sector's strong growth
Countrys Index level % change
June 01,2006 May 10, 2006
Hong Kong 15,912.7 17,080.6 -6.8
Korea 1,309.0 1,451.1 -9.8
Taiwan 6,959.6 7,324.7 -5.0
India 10,451.3 12,612.4 -17.1
Malaysia 930.7 966.6 -3.7
Philippines 2,304.2 2,529.5 -8.9
Indonesia 1,347.7 1,539.4 -12.5
Thailand 722.6 784.3 -7.9
Mexico 19128.63 21781.07 -12.2
Brazil 37748.3 41751.5 -9.6
Source: Bloomberg, Sharekhan Research
% yoy growth
4
6
8
10
12
14
Apr-05
May-05
Jun-05
Jul-05
Aug-05
Sep-05
Oct-05
Nov-05
Dec-05
Jan-06
Feb-06
Mar-06
IIP Manufacturing index
Returns on the emerging market equities (%)
We believe that the concerns over India, as reflected in the steep correction in its benchmark indices, have been
overdone for two reasons as mentioned below.
India has had more than its fair share of pain
Source: Bloomberg, Sharekhan Research
We have frequently mentioned that the Indian economy was taking a breather during the period November-December
2005 and that we expected it to bounce back in the last quarter of FY2006. The recent economic data vindicates our
view. The Index of Industrial Production has grown by 8.1% in Q4FY2006 compared with a growth of 7.1% and 6.5% in the
previous two quarters. The manufacturing sector grew by 9% for the same quarter compared with a growth of 8.1% and
7.8% in the previous two quarters. We expect the growth to continue inApril 2006 as is indicated by the leading indicators
like electricity production and sales of motorcycles, commercial vehicles and cement dispatches.
Economic indicators—strong growth continues
Correction overdone for two reasons
w The correction in the Indian benchmark indices has been
much more than that in the peer indices in the other
emerging markets and even more than that in the vari-
ous commodities like aluminium, copper, zinc and gold.
w India's share in the FII money outflow has also been
much more than that of its peers: Of the total net sell-
ing of US$7.4 billion of equity by the FIIs in the emerg-
ing Asian markets, nearly US$1.9 happened in India.
w Despite such huge selling, the FIIs are net buyers of
US$2.2 billion of Indian equity in YTD CY2006—nearly
one-fourth of net equity investments made by the FIIs
in the emerging Asian markets.
Markets correct across the globe

4. 4 June 2006Sharekhan
market outlook More than our fair share of pain
Source: Bloomberg
w The growth in the earnings of the companies constitut-
ing the Sensex stands at a strong 21% for FY2007E.
w The growth for FY2008E stands at 11%.
FY2007E EPS growth stands at 21.0%
Upgrades in earnings growth of sensex companies for FY2007E (%)
13.2 13.4
14.4
15.3
16.2
17.7
18.6
19.0
21.0
13.0
15.0
17.0
19.0
21.0
Aug-05
Sep-05
Oct-05
Nov-05
Dec-05
Jan-06
Feb-06
Mar-06
Apr-06
We have been mentioning that although the earnings momentum of the Sensex has slowed down a bit, yet the same
appears strong when compared with that of its peers in Asia as well as in the other emerging markets like Brazil and
Mexico. The growth in the earnings of the Sensex companies for FY2007E is likely to be strong at 21% while that for
FY2008E is likely to be at 11.5%.
The earnings of the Sensex companies for the quarter ended March 2006 grew by 23.4% year on year (yoy) and by 21.3%
quarter on quarter (qoq) compared with the expectations of an 18.9% growth yoy and a 16.8% growth qoq.
The Sensex' valuation has corrected by over 17% over the last two months (from 12,310.7 at the end of April 2006 to
10,204 in June 2006) to 14.2x its 12-month forward earnings, which is now near its ten-year average.
Growth story remains intact—Sensex’ valuation has corrected by 17%
w Strong growth expected in April 2006 as is indicated by
the upswing in the consumption of commercial vehicles,
motorcycles, cement and production of coal and elec-
tricity.
Leading indicators reflect strong growth for April 2006
Indicator % growth Trend
Jan-06 Feb-06 Mar-06 Apr-06
Cement 14.3 15.8 15.4 10.2 Up
Commercial vehicles 13.8 18.1 23.4 63.6 Up
Motorcycles 15.3 17.6 21.3 18.2 Up
Coal 10.5 9.3 7.2 3.4 Down
Electricity 5.8 9.0 3.2 5.6 Flat
Source: CMIE, Sharekhan Research
Source: Ministry of commerce and industry
w The underlying investment expenditure (capex) theme
remains strong.
w The Index of Capital Goods grew by a strong 26.3% for
January 2006.
w Broad-based growth with categories like boilers, tex-
tiles machinery, industrial machinery posting strong
gains.
Underlying capex theme going strong
Growth in capital goods index (% YTD)
13.0
14.0
15.0
16.0
17.0
18.0
Apr-05
May-05
Jun-05
Jul-05
Aug-05
Sep-05
Oct-05
Nov-05
Dec-05
Jan-06
Feb-06
Mar-06

5. 5 June 2006Sharekhan
market outlook More than our fair share of pain
Source: Sharekhan Research
# for 28 companies that have declared results
Source: Sharekhan Research
w The earnings of the Sensex companies have grown by
23.4% yoy in Q4FY2006.
w The expected growth was 18.9% yoy.
Source: Sharekhan Research
w The Sensex has usually traded between 12x and 16x its
one-year forward price/earnings ratio (PER) over the
last ten years.
w At 14.2x its FY2007E EPS the Sensex' valuation has cor-
rected by over 17% from its peak.
One-year forward PER (x)
Strong growth in Q4FY2006 earnings
Discount in the valuations narrowing—we prefer large caps
w While the discount between the trailing twelve-month
PER of the CNX Mid-cap 200 and that of the Sensex was
as high as 24% in June 2004 and 10.7% in June 2005, it
has almost flattened out now at the beginning of June
2006.
Sensex 1-yr forwardPER(x)
8.0
13.0
18.0
23.0
28.0
Jan-94
Jan-95
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Growth in Sensex earnings (%)
0
10
20
30
40
50
Q3FY05
Q4FY05
Q1FY06
Q2FY06
Q3FY06
Q4FY06#
Expected Actual
PER (x) and discount (%)
9
11
13
15
17
19
21
Sep-04 Dec-04 Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06
0
5
10
15
20
25
30
Sensex (LHS) Midcap 200 (LHS) Premium/(Discount) (RHS)
To be on the safer side, we prefer to take exposure to large-cap stocks rather than the mid-cap and small-cap stocks.
With a good run-up in the prices of the mid-cap and small-cap stocks, the gap between the valuation of the CNX Mid-cap
200 and the Sensex has narrowed down considerably over the last two years.
We prefer large caps over small caps for a while

6. 6 June 2006Sharekhan
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market outlook More than our fair share of pain